Happy New Year. We enter 2012 with a great deal of hope, but our hopes are not for more bailouts, or money printing, or any of the myriad policies that investors seem to hope will save bad investments and sustain elevated valuations. Instead, our hope is that in 2012, the market will finally “clear,” in the sense that bad debt will be recognized as bad and restructured; that overleveraged financials will be taken into receivership instead of forcing austerity on every corner of the economy in order to make them flush again; that rates of return will rise enough to compensate and encourage saving – and high enough to encourage borrowers and other users of capital to allocate the funds productively. Of course, in order to restructure bad debt, someone has to accept a loss. In order for rates of return to rise, valuations must decline. In short, our hope is for events that will unchain the global economy from an irresponsible past and open the gates toward a prosperous future. Maybe that is too hopeful, but we are not entirely convinced that bailouts and “big bazookas” will be as easily procured in the year ahead as a confused public has allowed in recent years.

We begin 2012 with the S&P 500 priced at valuations from which we estimate 10-year total returns of just 4.9% annually. This figure would be less discouraging if it were not for the fact that valuations – properly normalized for the cyclicality of earnings – have been tightly related to subsequent returns as far back as one cares to look, and as recently as the past decade. It is true that rich valuations did not prevent the late 1990’s bubble (corresponding to late 1980’s 10-year total return projections), but the ultimate and predictable outcome of that bubble has been more than a decade of stagnant returns. Back in 2000, it seemed inconceivable that we could be projecting negative 10-year total returns, but that outcome was the natural result of the valuations we observed at the time. Weak returns over the coming decade (hopefully front loaded as a few years of negative returns, followed by normal or above-average returns in the out-years) are likely to be an equally natural result of present conditions.